Ways India’s Cash Squeeze Is Going to Affect the Economy

The Indian government’s decision last week to withdraw 500- and 1,000-rupee bills with immediate effect, a move aimed at cracking down on corruption and counterfeiting, was welcomed by many economists, one of whom said it was “masterstroke.” But the sudden announcement has led to a cash shortage, with long queues snaking toward high-street banks as people wait to swap their old bills for new ones. Some business has come to a standstill, particularly in the informal economy that relies on cash, raising questions about the efficacy of the government’s move. Here’s how the economy could be affected.

Long term, economic growth is expected to get a boost from the move as it leads to greater tax compliance, moderates prices and increases the government’s tax revenue. But for now, growth is expected to take a hit as a shortage of currency bills slams the brakes on consumption, which accounts for about 60% of the country’s gross domestic product. Yes Bank estimated Friday that India’s gross domestic product would rise 7.5% to 7.6% in the year through March, down significantly from its previous view of 8.1%. “In addition to the pullback in consumption, which would take at least a quarter to normalize, cash-intensive sectors such as real estate and construction would be adversely affected,” it said in a note. “The spillover will reflect in lower demand for cement, steel, commercial vehicles and construction equipment,” it added.

A significant chunk of the money hidden from tax authorities may never get disclosed because there isn’t any significant financial incentive for cash hoarders to do so. The government will take away 90% of any such undisclosed wealth in tax and penalties, which might mean hoarders consign the money to trash instead of risking prosecution. If that money doesn’t return to the financial system, the liabilities of the central bank will come down. A lower liability would mean the central bank will have more money to give back to the government, for whom it serves as a money manager. The government’s revenue would also rise as a higher number of Indians come into the tax net. Sujan Hajra, chief economist at Anand Rathi Securities, estimated that New Delhi could be looking at a windfall of between 3 trillion rupees ($44 billion) and 5 trillion rupees over the next two years. If the government decides to use that money to fund its budgetary deficit, it could narrow to below 3% of gross domestic product this fiscal year compared with the projected 3.5%, he added.

As part of the move, India is withdrawing currency bills worth about 14.7 trillion rupees from circulation. Even assuming that a significant part of this cash would leave the banking system when people withdraw it, there could still be a large portion of funds that may remain with banks as more people shift to online transactions. Madan Sabnavis, chief economist at Care Ratings, estimates banks could be looking at a cumulative increase of 5.5 trillion rupees in deposits. That would provide a massive boost to Indian banks, particularly those owned by the government, as they look for fresh capital to give more loans to companies and strengthen economic growth.

The central bank has cut rates several times since January 2015 and has been unhappy that banks are refusing to pass on the cuts to customers. But if banks are flush with cash, they could slash interest rates on deposits and, in turn, lower the rates they charge from borrowers. If banks do pass on the Reserve Bank of India’s rate moves, another cut by the central bank could be less likely, says Madan Sabnavis, chief economist at Care Ratings. “There is no need for the RBI to lower rates at this stage given that rates are going to come down on their own,” he says. There is a downside. The country’s small savers, particularly those retired and living on interest income, would suffer.

The troubles of India’s real-estate sector, which is already in the midst of a sharp slowdown, could deepen. Transactions in the sector typically involve a significant amount of cash exchange aimed at avoiding tax by under-reporting the value of the deal. But with such hidden money expected to move out of the market, prices could tumble. “The demonetization move is likely to result in luxury-property prices dipping by as much as 25%-30% as sellers struggle to offload properties to generate liquidity,” said Ashwinder Raj Singh, chief executive officer of residential services, for JLL India.